Good morning, and thank you to RFi for the opportunity to speak to you today.
Property markets and financial stability are both topics that are dear to my
heart, and I hope to yours as well. It has been known for generations that
boom-bust cycles in asset prices can be harmful to the economy and the people
in it. They are especially harmful when fuelled by easy credit. Sadly, that
knowledge has not stopped the busts occurring. The source of the threat to
financial stability is more often in commercial property or property development
than in home mortgages, so I think we need to keep the risks posed by the housing
and home mortgage markets in perspective. Still, if something did go badly
wrong in the housing market, it would be painful and could damage financial
stability. I therefore want to go through some of the reasons why households
might default on their mortgages, explain why the US market became so distressed,
and show how we can continue to avoid a similar situation.

Is housing really the problem?

Although this talk is about home mortgages, I want to emphasise that home mortgage
markets with prudent lending standards do not generally pose risks to financial
stability. It is not unusual for housing prices to fall, especially if they
had been booming previously, or if the economy has turned down. But for that
to translate into a big upswing in mortgage defaults, the economy generally
has to have weakened first. That was the pattern of the housing busts of the
1930s and early 1990s in many countries. It is also what we see in Ireland,
Spain and the United Kingdom today. In those countries, as in the past, commercial
real estate and property development have been the bigger problems. The recent
cycle in commercial property prices has been at least as large as that in housing
prices for essentially every country for which we have good data, including
the United States as well as countries like Spain and Ireland (Graph 1).

Graph 1

Typically, the rate of home mortgage defaults remains low enough that it does
not damage the financial system as much as property-related corporate loan
defaults. The effects therefore do not feed back to the real economy to the
same extent. All the same, the recent US experience shows that painful housing
busts can happen. We would certainly want to avoid one here. Housing lending
is a larger fraction of the balance sheets of Australian banking institutions
than for their US counterparts. So in the unlikely event a US-style bust did
happen, it would be harmful to financial stability in Australia.

We should seek to avoid US-style housing busts, not only because they harm financial
stability, but also because they impose great social costs. Losing money in
a failed property investment is one thing, but how much worse would it be to
lose your home? Millions of American households have lost their homes to foreclosure.
Whole neighbourhoods have been blighted by empty and even uninhabitable homes.
Communities are fractured and lives are disrupted, sometimes permanently.

There is no reason why Australia should follow the same path as the United States
in this respect. But it is important that we continue to avoid the same mistakes.
By ‘we’, I do not refer only to policymakers. Mortgage lenders
need to refrain from easing lending standards the way they did in the United
States. And so far, you have been refraining. It is a key difference between
the two countries, and it motivates the title of my talk today.

Why do some households default on their mortgages?

There is a common misconception that US home buyers can just walk away from
their mortgage, and will do so whenever the value of their home falls below
their loan balance. Non-recourse lending applies in some states for some borrowers,
but the law in most US states allows lenders to sue for any remaining shortfall
from the proceeds of sale of foreclosed homes. It is just that many do not
bother going to court to obtain a ‘deficiency judgement’, as they're
known. Experience has shown that households are much less likely to default
on their mortgages than a simple financial test would imply (Vandell 1995).
Rather than just giving up and walking away at the first sign of difficulty,
many borrowers strive to maintain their repayments or to get back on track
after falling behind (Foote, Gerardi and Willen 2008).

Instead of imagining a ‘ruthless defaulter’ who walks away from
their financial obligations, we need to focus more on capacity to pay and how it can decline. The reality is that things
can happen to people that make it difficult to repay their loans – their
relationships break down, or they lose their jobs, or a member of the family
becomes too ill to work or even dies. We economists and credit risk modellers
speak euphemistically of idiosyncratic shocks, but this is what we mean. Financial
stability policymakers cannot legislate away these individual setbacks, but
we can be alert to circumstances that could make them more common or more damaging.

The most obvious factor that can make things worse is a recession. In good times,
the people most at risk of losing their jobs are less likely than average to
have a mortgage. As unemployment rises, though, many more people face a loss
of income, and more of them are likely to have mortgages. So the really large
upswings in mortgage arrears rates have, perhaps not surprisingly, tended to
occur at the same time as large increases in unemployment. This is certainly
the experience in countries like the United Kingdom and Spain in recent years
(Graph 2).

Graph 2

Falling housing prices are another factor that tends to result in higher rates
of mortgage arrears. If something bad happens to you and you can no longer
afford your repayments, it is better to sell and have a bit left over after
discharging the mortgage. If the property value has fallen below the loan balance,
though, you are in a much worse situation. You can't easily sell if you
are in trouble or even if you just want to move to a cheaper area or a more
appropriate home, or to where the jobs are.

So we need to be alert to falling housing prices, but we also need to keep them
in perspective. There still needs to be an underlying problem with the borrower's
ability to repay before they default. A note of caution, though: housing price
growth is no longer running ahead of income growth the way it did during the
1990s and early 2000s, when the economy was still adjusting to disinflation
and deregulation (Graph 3). And because inflation and thus income growth
are lower than in the 1970s and 1980s, soft periods in the housing market could
now be more likely to involve falling housing prices.

Graph 3

Mortgage debt is a nominal quantity, fixed in dollar terms until the borrower
pays some of it down. So if periods of mild price falls are more common nowadays,
households are more likely to end up in negative equity unless they do something
about it, by paying back principal. I will have more to say about this in a
moment. For now, just consider that higher debt burdens make it more likely
that a household will run into repayment difficulty. And now that the transition
period is over, low inflation makes it more likely that households in difficulty
will also be in negative equity.

The meltdown in the US housing market cannot be explained by these factors alone,
however. Mortgage arrears began rising rapidly well before unemployment did,
even when housing prices had fallen only modestly (Graph 4). Had capacity
to pay deteriorated so much? It is to this question that I now want to turn.

Graph 4

What went wrong in the United States?

Much has been written on the causes of the crisis and the housing bust that
sparked it, including by me. The causes are complex, but I think they can be
boiled down to three things: lax lending practices, lax lending practices,
and lax lending practices. Lending standards eased in the United States far
beyond what was seen in other countries over the boom period. Partly this was
because certain specialist subprime lenders gained market share, but individual
lenders also lowered their standards.

Subprime lending has long been a niche in US mortgage finance. The traditional
players in this market understood that it was a very risky customer base. These
borrowers are, after all, people with a history of missing payments on other
debt. During the boom in subprime mortgages, US lenders thought they could
manage their exposure to these risky borrowers by ensuring they would not remain
customers for long. They tried to enforce this with loan terms that induced
borrowers to refinance after a few years, like large scheduled increases in
required repayments. But if credit wasn't available elsewhere and the borrower
couldn't afford the higher subsequent repayments, default might have been
the only option.

Much of the subprime and other non-prime lending that went on was not based
on proper assessments of borrowers' ability to service the loan. Brokers
and lenders did not verify incomes or other financial obligations. All they
seemed to care about was the value of the collateral. If housing prices kept
rising, they assumed, the borrower could either refinance or sell, and everything
would be fine. Big assumption. We would never want to see this kind of asset-based
lending in the Australian market.

So subprime markets and lax lending decisions were key differences between the
US and Australian markets. What happens during the life of the loan also matters
a great deal. Some recent research by economists at the Federal Reserve suggests
that it was not high proportions of subprime loans that predicted which districts
would have worse outcomes for prices and loan defaults (Barlevy and Fisher
2010). Rather, it was the proportion of new lending that was interest-only
loans. These loans were not being paid down. In some cases, the loan balance
was increasing through cash-out refinancing or explicit negative amortisation
options.

How are Australia and other countries avoiding a US-style situation?

As the RBA has made clear many times before, one important reason Australia
did not go down the same road as the United States is that lending standards
didn't ease as much here. Even at its peak, subprime lending was only ever
a tiny fraction of the total. Low-doc loans were also a small niche. And we
never saw here the explosion of zero-deposit loans – or worse, the 125 per cent
loans that were available in the United Kingdom. In Australia in recent years,
around two-thirds of new mortgage borrowers from banks had an initial loan-to-valuation
ratio below 80 per cent. If we look at the whole mortgage book, that
fraction is even higher.

A large part of the reason why lending standards didn't ease as much here
is that prudential supervision is stricter. Unlike in the United States, in
Australia most mortgage lending is done by firms that are prudentially regulated.
And unlike in the United States, there is only one prudential supervisor, APRA.
Australian lenders can't arbitrage differences in prudential treatment
across different regulators.

There are quite a few mortgage lenders that are not prudentially supervised,
though, and this is where an important second line of defence comes in. Consumer
protection standards around credit are a vital part of the authorities'
defence against a US-style outcome, a part that in my view has been under-appreciated
to date. Consumer protection standards for credit products have in recent years
been broadened, and shifted to a national framework administered by ASIC. But
the earlier state-based system still had the three features most needed to
avoid US-style problems: it was nationally consistent; it covered all consumer
borrowers; and it covered all lenders consistently, regardless of whether they
were prudentially supervised or not.

Another important mainstay against a US-style outcome is that many Australian
households actually pay their mortgages down, often quite quickly (Graph 5).
Estimates vary, but it seems as many as half of owner-occupiers with mortgages
pay it down faster than the contract requires. The faster they pay it down,
the less likely they are to end up in negative equity; they have a head start
if prices should fall. Some of them must be running their debt down quite fast:
data from lenders suggest that the total amount of excess repayments made is
similar to the amount of required repayments. This is a welcome feature of
the Australian market that is rarely seen overseas.

Graph 5

The international regulatory community is all too aware of the role of lax lending
practices in the US meltdown. In response, the Financial Stability Board (FSB)
has drafted some global principles for sound mortgage lending practices, which
all countries should
follow.[1]
These principles were released for consultation last year and should be finalised
quite soon. I was part of the group that drafted these principles, so naturally
I commend them to you. The Principles recognise that lending standards are
multidimensional. This is a crucial point. Many factors affect a borrower's
capacity to repay their loan. Some of them are complementary; others can offset
each other.

The international debate about so-called ‘macroprudential policy’
and financial stability policy more generally has been quite focused on housing
and mortgages. For instance, there has been a lot of talk about the idea of
the authorities setting a cap on loan-to-valuation ratios (LVRs), and periodically
adjusting that cap. Some countries already do this. The FSB did not mandate
or specifically encourage such a policy tool, and we do not think it is necessarily
warranted in the Australian environment. It is, of course, important that borrowers
put some of their own resources into the purchase of their home. But the focus
should not be on maximum LVRs at origination, ignoring all other aspects of
lending standards. In my view, capacity to service the loan is far more important.

Looking at LVRs just at origination also ignores how these ratios evolve over
the life of the loan, and how they are distributed across households. In Australia,
households in aggregate used to have very little debt against their homes,
relative to the value of those homes, back when the financial sector was highly
regulated and inflation eroded that debt quickly (Graph 6). Obviously
this measure of leverage has risen since then. It would not be desirable for
this ratio to approach that in the United States. However, we do not think
the most effective way to prevent that would be to impose a cap just for new
borrowers.

Graph 6

Nor do we think it is sensible to rely on simple rules like a ratio of loan
amount to income; nowadays many Australian lenders sensibly take borrowers'
other obligations and expenses into account when determining how much debt
can be serviced, and thus how much they will lend.

The Principles themselves deal with the various dimensions of lending standards in
their own order, but I like to group those dimensions into five categories.

First, serviceability: or in simpler terms, capacity to pay. This
is covered in Principle 2 of the FSB proposal. It is the crucial decision
of how much to lend. And I think it is the decision point where it is all
too easy to become complacent and lend too much.

Lenders should also consider over what term the loan is to be serviced.
The term affects how quickly the loan is paid down. As the Principles also
note, if the loan term extends past normal retirement ages, lenders need to
allow for that when assessing capacity to pay. Don't assume, without
good reason, that borrowers will necessarily downsize when they retire.

Amortisation of the loan is also important. Principle 2.1 in the FSB
document states: ‘Jurisdictions should ensure that lenders appropriately
assess borrowers' ability to service and fully repay their loans without
causing them undue hardship.’ The National Consumer Credit Code in Australia
says something similar. Interest-only loans have their place, but the point
about mortgage lending is that the household should be able to pay it off
eventually. Otherwise we would be in the undesirable world of asset-based
lending.

Of course, we do have to think about collateralisation, or loan-to-valuation
ratio. This is covered in Principle 3 of the proposal, where the FSB emphasised
the need to avoid allowing higher LVRs just because housing prices happen
to be rising. Principle 4 covers how that valuation should be arrived at.

Finally, subordination greatly affects loan performance. Some of the
worst loss outcomes in the US meltdown occurred in portfolios of second mortgages,
and the structured securities based on them. Sometimes the lender for the
first mortgage didn't even know that the second mortgage existed.

Within each of these dimensions, both lenders and policymakers need to think
about more than just the explicit loan terms. We must consider the variability of those terms, and of the circumstances of the borrower.
For example, does the borrower have an unusually volatile income or employment
history? And have both the borrower and lender allowed enough of a margin to
cope with interest rate changes? We must also consider who has the option
to vary those loan terms. Australian borrowers' tendency to repay ahead
of schedule is a good example of this. And we must consider whether and how
the lender can verify that the information they base their decisions
on is true. This last aspect is so important that the FSB made it the first
of the Principles. The problems with stated income loans – and even outright
fraud – in the US market during its boom, show how important verification
can be.

Conclusion

In conclusion, I would like to stress that Australia, like many other countries,
does not have the ingredients needed to create an outcome like that in the
United States. But in ensuring that remains the case, much will depend on you,
the mortgage lenders.

If I may use an analogy: we know that the key to maintaining a healthy weight
is to have a healthy diet and to exercise regularly. Yet we find it hard to
avoid temptation. And so it is with maintaining a healthy mortgage market.
It is always tempting to ease lending standards, and dress that up as responding
to competition or giving the customer a better deal. It must be hard to resist
the disappointed customers who just want to borrow that bit extra to purchase
their dream home, especially when the loan officer is also trying to make budget
on new loan approvals. But in the experience of the United States, we have
seen what can happen when lenders yield to that temptation.

If lenders were to ease lending standards beyond the point of prudence, they
would not be doing anyone any favours. Their customers, the borrowers, would
be overburdened by their debts. The firm themselves would face difficulties
if loan defaults were to rise. And financial stability would be much harder
to maintain. I am pleased to say that I do not currently see signs of widespread
lax lending practices here in Australia. Indeed, APRA has been consulting with
the boards of the larger banking institutions about their housing lending standards.
But there will be times – good times, when everything seems rosy –
when lenders will find it hard to maintain the necessary prudence. While the
regulators can take actions and central bankers like me can warn of the risks,
in the end we all have a stake in maintaining financial stability. For financial
stability is in the collective interest of all Australians.

Thank you for your time.

Endnote

See <http://www.financialstabilityboard.org/publications/r_111026b.pdf>. The
report uses the term ‘underwriting practices’, which is commonly
seen in the United States and some other jurisdictions.
[1]